FUNDAMENTALLY; Look Out: Investors Are Turning Optimistic

By PAUL J. LIM

Published: November 26, 2006

PESSIMISM has been propelling the stock market.

Of course, that gloom -- contrarian indicator though it may be -- isn't enough on its own. But combine it with strong economic and profit growth and you end up with a series of positive earnings surprises. And this, in turn, has fueled the 4.9 percent rally in the Standard & Poor's 500-index so far this quarter and the 12.2 percent gain for the year to date.

In fact, investors have become downright optimistic in recent weeks, thanks in part to an avalanche of solid earnings reports and economic data.

For example, 59 percent of fund managers now say they believe that the economy next year will remain as strong as it is now or will improve, according to a recent survey by Merrill Lynch. That's up from 32 percent of fund managers who thought so in October.

The percentage of investors who think that the economy is likely to slip into recession, meanwhile, has shrunk to 8 percent from 20 percent last month.

That's not the whole story. Investors are also growing more bullish about the outlook for corporate profits. Today, half of all domestic fund managers think that earnings will remain steady or improve in the coming 12 months. A similar survey in September showed that only 18 percent felt that way.

This degree of optimism is somewhat surprising, because earnings growth usually begins to slow noticeably as an expansion matures. And by historical standards, this expansion is already long in the tooth.

So what's with this what-me-worry attitude? Part of it has to do with recent government data showing that the economy is hanging tough. The latest Labor Department reports, for instance, showed that the economy was still creating a significant number of new payroll jobs without fanning the flames of inflation.

But something else is also at work.

''We have come to a point in the cycle where people have begun to extrapolate trends,'' said Richard Bernstein, chief investment strategist at Merrill Lynch. In other words, having grown accustomed to a resilient economy and improving profits, investors now simply assume that times will always be this good.

Mr. Bernstein says it is particularly curious that investors are becoming more bullish on earnings while hoping that the Federal Reserve will soon start to trim short-term interest rates. For corporate earnings to improve substantially, the underlying economy would have to expand faster than expected. Yet, if economic growth were accelerating, the Fed wouldn't be easing monetary policy. Instead, it would probably still be raising rates.

Nevertheless, isn't this growing sense of optimism a bullish indicator for equity prices? Actually, ''this type of thinking can be very dangerous,'' Mr. Bernstein said.

That's because the aging bull market has thrived recently as investors have set the bar low and watched as corporate profits have consistently exceeded expectations.

In the third quarter, for instance, investors had been bracing for 14 percent earnings growth, compared with the year-earlier period. But they were pleasantly surprised when profits for the S.& P. 500 companies grew by 19 percent.

Now the situation is likely to reverse. It appears that investor expectations are rising just as corporate earnings are on the verge of disappointing.

How do we know that earnings will begin to slow? For starters, history has shown a strong correlation between corporate earnings growth and the spread between 10-year Treasury yields and the federal funds rate, Mr. Ablin said.

Whenever 10-year Treasuries are yielding less than the federal funds rate -- the rate that banks charge one another on overnight loans -- corporate earnings tend to slow or go negative, Mr. Ablin noted. And in case you haven't been paying attention, 10-year Treasuries have been yielding less than the fed funds rate for much of this year.

There are other signs as well. For example, the research firm Thomson Financial routinely surveys Wall Street analysts about their earnings expectations for the individual companies they follow. Thomson then adds up these forecasts to build a so-called bottoms-up estimate of equity earnings.

According to the most recent Thomson survey, S.& P. 500 earnings are expected to expand 9.6 percent in the fourth quarter. That would be a major slowdown from the third quarter, and even the second quarter, when profits rose 16.3 percent.

It would also be the slowest rate of earnings growth since the second quarter of 2003.

IN reality, profits for most S.& P. 500 companies are growing much slower than 9.6 percent this quarter. If you stripped out the financial sector, where a profit surge of 32 percent is expected, corporate earnings would be likely to grow by only 3.1 percent, said John Butters, senior research analyst for Thomson Financial.

And this slowdown is likely to continue through 2007. Many economists and market strategists, for example, are forecasting only modest single-digit earnings growth next year.

Jeffrey N. Kleintop, chief investment strategist at PNC Wealth Management in Philadelphia, says he thinks that S.& P. 500 earnings may grow by only 3 percent next year. And this assumes that the economy expands at an annual rate of around 2.5 to 3 percent, he said.

''If we see something worse -- something in the 1 to 2 percent range -- there could be a lot more downside to earnings growth,'' he said.

In fact, he added, ''it could pull the whole year into negative territory.''

Chart: ''A Slowdown in Earnings?''
For the last few years, corporate earnings have grown much faster than expected, which has helped to fuel equity markets. But corporate profits are expected to begin a descent in the fourth quarter this year.

Graph tracks S.& P. 500 earnings growth rate from the last two quarters of 2003 through estimated first two quarters of 2007.